**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **ý** |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**  |
|------------|--------|-----------------------------------------------------------------------------------------------|
|       |   |                                                                                          |
|       |   | **For the  quarterly period ended March 31, 2003**                                            |
|       |   |                                                                                          |
|       |   | **OR**                                                                                        |
|       |   |                                                                                          |
| **o**      |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|       |   |                                                                                          |
|       |   | **Commission  file number 0-12638**                                                           |

 

**F&M BANCORP**

(Exact name ofregistrant as specified in its charter)

* *

| **Maryland**                                                     |   | **52-1316473**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **110 Thomas Johnson Drive  Frederick, Maryland 21702**          |
| (Address  of principal executive offices) (Zip Code)             |
|                                                             |
| **(888) 694-4170**                                               |
| (Registrant’s  telephone number, including area code)       |
|                                                             |
| Securities registered pursuant  to Section 12(b) of the Act:     |
| **NONE**                                                         |
|                                                             |
| Securities registered pursuant  to Section 12(g) of the Act:     |
| **Common Stock ($5 par value)**                                  |
| (Title  of class)                                                |

* *

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

Common Stock of 10,768,101 shares outstanding asof April 23, 2003.

 

 

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Form 10-Q

TABLE OF CONTENTS

 
| **PART  I**   | **Financial  Information**                                                                              |
|---------------|---------------------------------------------------------------------------------------------------------|
| Item 1.       | Financial Statements                                                                                    |
|          | Consolidated  Statements of Income (Unaudited)                                                          |
|          | Consolidated Balance Sheets                                                                             |
|          | Consolidated  Statements of Changes in Shareholders’ Equity and Comprehensive Income  (Unaudited)  |
|          | Consolidated  Statements of Cash Flows (Unaudited)                                                      |
|          | Notes  to Financial Statements (Unaudited)                                                              |
|          |                                                                                                    |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  (MD&A) |
|          | Summary  Financial Data                                                                                 |
|          | Overview                                                                                                |
|          | Earnings  Performance                                                                                   |
|          | Net  Interest Income                                                                                    |
|          | Provision for Credit Losses                                                                             |
|          | Noninterest  Income                                                                                     |
|          | Noninterest  Expense                                                                                    |
|          | Balance  Sheet Analysis                                                                                 |
|          | Securities Available for  Sale                                                                          |
|          | Loan Portfolio                                                                                          |
|          | Nonaccrual Loans and  Other Assets                                                                      |
|          | Nonaccrual  Loans and Other Real Estate Owned                                                           |
|          | Allowance for Credit Losses                                                                             |
|          | Deposits                                                                                                |
|          | Capital  Adequacy/Ratios                                                                                |
|          | Contractual  Obligations and Other Commitments                                                          |
|          | Asset/Liability  and Market Risk Management                                                             |
|          | Capital  Management                                                                                     |
|          |                                                                                                    |
| Item  3.      | Quantitative  and Qualitative Disclosure about Market Risk                                              |
|          |                                                                                                    |
| Item 4.       | Controls and Procedures                                                                                 |
|          | Factors that May  Affect Future Results                                                                 |
|          |                                                                                                    |
| **PART II**   | **Other Information**                                                                                   |
| Item  4.      | Submission  of Matters to a Vote of Security Holders                                                    |
|          |                                                                                                    |
| Item 6.       | Exhibits and  Reports on Form 8-K                                                                       |
|          |                                                                                                    |
| **Signature** |                                                                                                    |

 

The information furnishedin these interim statements reflects all adjustments that are, in the opinionof management, necessary for a fair statement of the results for such periods.Such adjustments are of a normal recurring nature, unless otherwise disclosedin this Form 10-Q.  The results ofoperations in the interim statements are not necessarily indicative of theresults that may be expected for the full year. The interim financialinformation should be read in conjunction with F&M Bancorp’s 2002 AnnualReport on Form 10-K.

 

2

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**PART I –FINANCIAL INFORMATION**

**F&MBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME (Unaudited)**

 
|                                                  |   | **Quarter ended March 31,** |       |
|-------------------------------------------------------|--------|-----------------------------|------------|
| **(in thousands, except shares)**                     |   | **2003**                    |       | **2002** |   |
| **INTEREST INCOME**                                   |   |                        |       |   |   |
| Loans                                                 |   | **$**                       | **20,490** |   | $ | 20,991 |   |
| Loans held for sale                                   |   | **296**                     |       | 292 |   |
| Securities available for sale                         |   | **6,356**                   |       | 6,520 |   |
| Other interest income                                 |   | **94**                      |       | 160 |   |
| Total interest income                                 |   | **27,236**                  |       | 27,963 |   |
| **INTEREST EXPENSE**                                  |   |                        |       |   |   |
| Deposits                                              |   | **6,451**                   |       | 8,849 |   |
| Short-term borrowings                                 |   | **366**                     |       | 312 |   |
| Long-term borrowings                                  |   | **946**                     |       | 779 |   |
| Total interest expense                                |   | **7,763**                   |       | 9,940 |   |
| **NET INTEREST INCOME**                               |   | **19,473**                  |       | 18,023 |   |
| Provision for credit losses                           |   | **525**                     |       | 825 |   |
| Net interest income after provision for credit losses |   | **18,948**                  |       | 17,198 |   |
| **NONINTEREST INCOME**                                |   |                        |       |   |   |
| Service charges on deposit accounts                   |   | **2,113**                   |       | 2,196 |   |
| Insurance income                                      |   | **2,940**                   |       | 2,650 |   |
| Mortgage banking fees                                 |   | **678**                     |       | 845 |   |
| Trust and investment fees                             |   | **716**                     |       | 921 |   |
| Gains on sales of securities                          |   | **467**                     |       | — |   |
| Gains on sales of property                            |   | **36**                      |       | 86 |   |
| Other operating income                                |   | **1,381**                   |       | 1,315 |   |
| Total noninterest income                              |   | **8,331**                   |       | 8,013 |   |
| **NONINTEREST EXPENSE**                               |   |                        |       |   |   |
| Salaries                                              |   | **7,330**                   |       | 7,116 |   |
| Incentive compensation                                |   | **846**                     |       | 629 |   |
| Employee benefits                                     |   | **1,436**                   |       | 1,912 |   |
| Occupancy and equipment expense                       |   | **2,231**                   |       | 2,474 |   |
| Core deposit intangible                               |   | **246**                     |       | 215 |   |
| Other operating expense                               |   | **4,607**                   |       | 4,431 |   |
| Total noninterest expenses                            |   | **16,696**                  |       | 16,777 |   |
| **INCOME BEFORE INCOME TAX EXPENSE**                  |   | **10,583**                  |       | 8,434 |   |
| Income tax expense                                    |   | **3,384**                   |       | 2,657 |   |
| **NET INCOME**                                        |   | **$**                       | **7,199**  |   | $ | 5,777 |   |
| **EARNINGS PER COMMON SHARE**                         |   |                        |       |   |   |
| Earnings per common share                             |   | **$**                       | **0.67**   |   | $ | 0.53 |   |
| Diluted earnings per common share                     |   | **$**                       | **0.66**   |   | $ | 0.53 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                   |   | **$**                       | **0.29**   |   | $ | 0.28 |   |
| Average common share outstanding                      |   | **10,738,234**              |       | 10,852,687 |   |
| Diluted average common shares outstanding             |   | **10,843,032**              |       | 10,912,294 |   |

 

3

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**F&MBANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

** **
| **(in thousands, except shares)**                                                                                                            |   | **March 31,  2003** |          | **December 31,  2002** |   | **March 31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------------|------------------------|--------|---------------------|--------|
|                                                                                                                                         |   | **(Unaudited)**     |          |                   |   | **(Unaudited)**     |   |
| **ASSETS**                                                                                                                                   |   |                |          |                   |   |                |   |
| Cash and due from banks                                                                                                                      |   | **$**               | **67,022**    |                   | $      | 81,444              |   | $ | 63,675 |   |
| Federal funds sold                                                                                                                           |   | **10,210**          |          | 232                    |   | 12,909              |   |
| Total cash and cash equivalents                                                                                                              |   | **77,232**          |          | 81,676                 |   | 76,584              |   |
| Loans held for sale                                                                                                                          |   | **16,798**          |          | 28,722                 |   | 15,412              |   |
| Securities available for sale                                                                                                                |   | **627,633**         |          | 618,452                |   | 557,425             |   |
| Nonmarketable equity securities                                                                                                              |   | **7,274**           |          | 6,780                  |   | 6,866               |   |
|                                                                                                                                         |   |                |          |                   |   |                |   |
| Loans                                                                                                                                        |   | **1,317,789**       |          | 1,305,348              |   | 1,170,387           |   |
| Less: Allowance for credit losses                                                                                                            |   | **(13,673**         | **)**         | (13,668                | )      | (14,132             | )      |
| Net loans                                                                                                                                    |   | **1,304,116**       |          | 1,291,680              |   | 1,156,255           |   |
|                                                                                                                                         |   |                |          |                   |   |                |   |
| Bank premises and equipment, net                                                                                                             |   | **35,172**          |          | 36,024                 |   | 34,952              |   |
| Other real estate owned, net                                                                                                                 |   | **414**             |          | 414                    |   | 610                 |   |
| Interest receivable                                                                                                                          |   | **9,004**           |          | 9,513                  |   | 9,262               |   |
| Core deposit intangible                                                                                                                      |   | **1,640**           |          | 1,886                  |   | 2,602               |   |
| Mortgage servicing rights                                                                                                                    |   | **293**             |          | 580                    |   | 963                 |   |
| Cash value of life insurance                                                                                                                 |   | **12,262**          |          | 12,109                 |   | 11,133              |   |
| Other assets                                                                                                                                 |   | **6,631**           |          | 7,150                  |   | 11,459              |   |
| Total assets                                                                                                                                 |   | **$**               | **2,098,469** |                   | $      | 2,094,986           |   | $ | 1,883,523 |   |
|                                                                                                                                         |   |                |          |                   |   |                |   |
| **LIABILITIES & SHAREHOLDERS’ EQUITY**                                                                                              |   |                |          |                   |   |                |   |
| Liabilities:                                                                                                                                 |   |                |          |                   |   |                |   |
| Deposits:                                                                                                                                    |   |                |          |                   |   |                |   |
| Noninterest-bearing                                                                                                                          |   | **$**               | **294,382**   |                   | $      | 264,965             |   | $ | 238,430 |   |
| Interest-bearing                                                                                                                             |   | **1,355,251**       |          | 1,330,174              |   | 1,294,259           |   |
| Total deposits                                                                                                                               |   | **1,649,633**       |          | 1,595,139              |   | 1,532,689           |   |
|                                                                                                                                         |   |                |          |                   |   |                |   |
| Short-term borrowings                                                                                                                        |   | **163,636**         |          | 219,060                |   | 100,568             |   |
| Long-term borrowings                                                                                                                         |   | **77,918**          |          | 78,023                 |   | 63,420              |   |
| Accrued taxes and other liabilities                                                                                                          |   | **17,565**          |          | 18,508                 |   | 17,853              |   |
| Total liabilities                                                                                                                            |   | **1,908,752**       |          | 1,910,730              |   | 1,714,530           |   |
| Shareholders’ equity:                                                                                                                   |   |                |          |                   |   |                |   |
| Common stock, $5 par value; authorized 50,000,000  shares; issued 10,759,402 shares, 10,729,304 shares, and 10,852,840 shares,  respectively |   | **53,797**          |          | 53,647                 |   | 54,264              |   |
| Surplus                                                                                                                                      |   | **71,166**          |          | 70,598                 |   | 74,815              |   |
| Retained earnings                                                                                                                            |   | **54,197**          |          | 50,178                 |   | 37,549              |   |
| Accumulated other comprehensive income                                                                                                       |   | **10,557**          |          | 9,833                  |   | 2,365               |   |
| Total shareholders’ equity                                                                                                              |   | **189,717**         |          | 184,256                |   | 168,993             |   |
| Total liabilities and shareholders’ equity                                                                                              |   | **$**               | **2,098,469** |                   | $      | 2,094,986           |   | $ | 1,883,523 |   |

 

4

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**F&M BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES INSHAREHOLDERS’**

**EQUITY AND COMPREHENSIVE INCOME**(Unaudited)

 
| **(in thousands, except per share data)**                                                                                       |   | **Number  of shares** |       | **Common  stock** |       | **Surplus** |       | **Retained  earnings** |       | **Cumulative  other  comprehensive  (loss) income** |       | **Total**  |       |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|-------------------|------------|-------------|------------|------------------------|------------|-----------------------------------------------------|------------|------------|------------|
|                                                                                                                            |   |                  |       |              |       |        |       |                   |       |                                                |       |       |       |
| Balance at December 31, 2001                                                                                                    |   | 10,862,257            |       | $                 | 54,311     |        | $          | 75,147                 |       | $                                                   | 34,782     |       | $          | 3,185 |   | $ | 167,425 |   |
| Comprehensive income:                                                                                                           |   |                  |       |              |       |        |       |                   |       |                                                |       |       |       |
| Net income                                                                                                                      |   | —                |       | —            |       | —      |       | 5,777                  |       | —                                              |       | 5,777      |       |
| Other comprehensive income net of tax:                                                                                          |   |                  |       |              |       |        |       |                   |       |                                                |       |       |       |
| Net unrealized gains on securities                                                                                              |   | —                |       | —            |       | —      |       | —                 |       | (820                                                | )          | (820       | )          |
| Total comprehensive income                                                                                                      |   |                  |       |              |       |        |       |                   |       |                                                |       | 4,957      |       |
| Dividend reinvestment plan                                                                                                      |   | —                |       | —            |       | —      |       | (12                    | )          | —                                              |       | (12        | )          |
| Cash dividends declared ($.28 per share)                                                                                        |   | —                |       | —            |       | —      |       | (2,989                 | )          | —                                              |       | (2,989     | )          |
| Stock consideration for options exercised                                                                                       |   | (596                  | )          | (3                | )          | (4          | )          | (9                     | )          | —                                              |       | (16        | )          |
| Stock options exercised                                                                                                         |   | 14,579                |       | 73                |       | 183         |       | —                 |       | —                                              |       | 256        |       |
| Stock repurchase and retirement                                                                                                 |   | (23,400               | )          | (117              | )          | (511        | )          | —                 |       | —                                              |       | (628       | )          |
| Net change                                                                                                                      |   | (9,417                | )          | (47               | )          | (332        | )          | 2,767                  |       | (820                                                | )          | 1,568      |       |
| Balance at March 31, 2002                                                                                                       |   | 10,852,840            |       | $                 | 54,264     |        | $          | 74,815                 |       | $                                                   | 37,549     |       | $          | 2,365 |   | $ | 168,993 |   |
|                                                                                                                            |   |                  |       |              |       |        |       |                   |       |                                                |       |       |       |
| **Balance at December 31, 2002**                                                                                                |   | **10,729,304**        | ** ** | **$**             | **53,646** | ** **  | **$**      | **70,598**             | ** ** | **$**                                               | **50,179** | ** ** | **$**      | **9,833** | ** ** | **$** | **184,256** | ** ** |
| **Comprehensive income:**                                                                                                       |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                | ** ** |       | ** ** |
| **Net income**                                                                                                                  |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **7,199**              | ** ** | **—**                                          | ** ** | **7,199**  | ** ** |
| **Other comprehensive income net of tax:**                                                                                      |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                | ** ** |       | ** ** |
| **Net unrealized gains on securities available for sale, net  of reclassification of $287 of net gains included in net income** |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **—**             | ** ** | **724**                                             | ** ** | **724**    | ** ** |
| **Total comprehensive income**                                                                                                  |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                | ** ** | **7,923**  | ** ** |
| **Dividend reinvestment plan**                                                                                                  |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **—**             | ** ** | **—**                                          | ** ** | **—** | ** ** |
| **Cash dividends declared ($.29 per share)**                                                                                    |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **(3,113**             | **)**      | **—**                                          | ** ** | **(3,113** | **)**      |
| **Stock consideration for options exercised**                                                                                   |   | **(2,782**            | **)**      | **(13**           | **)**      | **(18**     | **)**      | **(68**                | **)**      | **—**                                          | ** ** | **(99**    | **)**      |
| **Stock options exercised**                                                                                                     |   | **32,880**            | ** ** | **164**           | ** ** | **586**     | ** ** | **—**             | ** ** | **—**                                          | ** ** | **750**    | ** ** |
| **Net change**                                                                                                                  |   | **30,098**            | ** ** | **151**           | ** ** | **568**     | ** ** | **4,018**              | ** ** | **724**                                             | ** ** | **5,461**  | ** ** |
| **Balance at March 31, 2003**                                                                                                   |   | **10,759,402**        | ** ** | **$**             | **53,797** | ** **  | **$**      | **71,166**             | ** ** | **$**                                               | **54,197** | ** ** | **$**      | **10,557** | ** ** | **$** | **189,717** | ** ** |

 

5

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**F&M BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOW**(Unaudited)

 
|                                                                                                        |   | **Quarter ended March 31,** |       |
|-------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
| **(in thousands)**                                                                                          |   | **2003**                    |       | **2002** |   |
| **Cash Flows from Operating Activities**                                                                    |   |                        | ** ** |   |   |
| Net income                                                                                                  |   | **$**                       | **7,199**  | ** ** | $ | 5,777 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities                           |   |                        | ** ** |   |   |
| Provision for credit losses                                                                                 |   | **525**                     | ** ** | 825 |   |
| Depreciation and amortization                                                                               |   | **733**                     | ** ** | 976 |   |
| Amortization of intangibles                                                                                 |   | **533**                     | ** ** | 296 |   |
| Net premium amortization on investment securities                                                           |   | **654**                     | ** ** | 799 |   |
| Decrease in interest receivable                                                                             |   | **509**                     | ** ** | 155 |   |
| Decrease in interest payable                                                                                |   | **(25**                     | **)**      | (300 | ) |
| Gain on sales of property                                                                                   |   | **(9**                      | **)**      | (86 | ) |
| Gain on sales of securities                                                                                 |   | **(467**                    | **)**      | — |   |
| Decrease in loans held for sale                                                                             |   | **11,924**                  | ** ** | 13,365 |   |
| (Increase) decrease in other assets                                                                         |   | **(498**                    | **)**      | 233 |   |
| (Decrease) increase in other liabilities                                                                    |   | **(916**                    | **)**      | 1,202 |   |
| Gain on sales of loans                                                                                      |   | **(678**                    | **)**      | (845 | ) |
| Net cash provided by operating activities                                                                   |   | **19,484**                  | ** ** | 22,397 |   |
| **Cash Flows from Investing Activities**                                                                    |   |                        | ** ** |   |   |
| Purchases of investment securities available for sale                                                       |   | **(138,950**                | **)**      | (61,839 | ) |
| Proceeds from sales/maturities of securities available  for sale                                            |   | **130,673**                 | ** ** | 48,867 |   |
| Net increase in loans                                                                                       |   | **(12,309**                 | **)**      | (7,972 | ) |
| Purchases of premises and equipment                                                                         |   | **(61**                     | **)**      | (365 | ) |
| Proceeds from sales of property                                                                             |   | **216**                     | ** ** | 157 |   |
| Net cash used in investing activities                                                                       |   | **(20,431**                 | **)**      | (21,152 | ) |
| **Cash Flows from Financing Activities**                                                                    |   |                        | ** ** |   |   |
| Net increase in noninterest-bearing deposits,  interest-bearing checking, savings and money market accounts |   | **56,670**                  | ** ** | 40,719 |   |
| Net decrease in certificates of deposit                                                                     |   | **(2,176**                  | **)**      | (24,098 | ) |
| Net decrease in short-term borrowings                                                                       |   | **(55,424**                 | **)**      | (16,977 | ) |
| Gross debt maturities in long-term borrowings                                                               |   | **(105**                    | **)**      | (24 | ) |
| Cash dividends paid                                                                                         |   | **(3,113**                  | **)**      | (2,989 | ) |
| Dividend reinvestment plan                                                                                  |   | **—**                  | ** ** | (12 | ) |
| Proceeds from issuance of common stock                                                                      |   | **651**                     | ** ** | 240 |   |
| Common stock purchased and retired                                                                          |   | **—**                  | ** ** | (628 | ) |
| Net cash used in financing activities                                                                       |   | **(3,497**                  | **)**      | (3,769 | ) |
| Net decrease in cash and cash equivalents                                                                   |   | **(4,444**                  | **)**      | (2,524 | ) |
| Cash and cash equivalents at beginning of year                                                              |   | **81,676**                  | ** ** | 79,108 |   |
| Cash and cash equivalents at end of period                                                                  |   | **$**                       | **77,232** | ** ** | $ | 76,584 |   |
| **Supplemental Disclosures of Cash Flow Information**                                                       |   |                        | ** ** |   |   |
| Cash payments for interest                                                                                  |   | **7,788**                   | ** ** | 10,239 |   |
| Cash payments for income tax                                                                                |   | **1,795**                   | ** ** | 541 |   |
| **Non-Cash Investing and Financing Activities**                                                             |   |                        | ** ** |   |   |
| Fair value adjustment for securities available for  sale, net of income taxes                               |   | **724**                     | ** ** | (820 | ) |

 

6

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**F&M BANCORP AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS **(Unaudited)

 

1.               Summary ofSignificant Accounting Policies

 

F&M Bancorp andSubsidiaries (consolidated) (the Bancorp) is a diversified financial servicescompany providing banking, insurance, investments, mortgage banking andconsumer finance through banking branches, the internet and other distributionchannels to consumers and businesses located primarily within the State ofMaryland.  F&M Bancorp (the Parent)is a bank holding company.

 

The accounting and reportingpolicies and practices of the Bancorp conform with accounting principlesgenerally accepted in the United States of America (“GAAP”) and prevailingpractice within the financial services industry. The preparation of financialstatements in conformity with GAAP requires management to make estimates andassumptions that affect reported amounts of assets and liabilities at the dateof the financial statements and income and expenses during the reportingperiod. Actual results could differ from those estimates. Certain amounts inthe financial statements for prior years have been reclassified to conform withthe current financial statement presentation.

 

Descriptions of thesignificant accounting policies of F&M Bancorp and Subsidiaries (theBancorp) are included in Note 1 (Summary of Significant Accounting Policies) tothe audited consolidated financial statements included in the Bancorp’s 2002Annual Report on Form 10-K. There have been no significant changes to thesepolicies.

 

The table below reflectsthe fair value-based accounting of stock options under the provisions of FASBStatement No. 148, *Accounting for Stock-Based Compensation.*

 
|                                          |   | **Quarter ended March 31,** |       |
|-----------------------------------------------|--------|-----------------------------|------------|
| **(in thousands, except per share  amounts)** |   | **2003**                    |       | **2002** |   |
| Stock-based compensation cost:                |   |                        |       |   |   |
| As reported                                   |   | **$**                       | **—** | ** ** | **$** | **—** | ** ** |
| Pro forma                                     |   | **227**                     |       | 56 |   |
| Net income                                    |   |                        |       |   |   |
| As reported                                   |   | **7,199**                   |       | 5,777 |   |
| Pro forma                                     |   | **7,060**                   |       | 5,743 |   |
| Earnings per common share                     |   |                        |       |   |   |
| As reported                                   |   | **$**                       | **0.67**   |   | $ | 0.53 |   |
| Pro forma                                     |   | **0.66**                    |       | 0.53 |   |
| Diluted earnings per common share             |   |                        |       |   |   |
| As reported                                   |   | **$**                       | **0.66**   |   | $ | 0.53 |   |
| Pro forma                                     |   | **0.65**                    |       | 0.53 |   |

 

7

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2.               BusinessCombinations

 

On March 13, 2003 theBancorp announced plans to be acquired by Mercantile Bankshares Corporation(Mercantile). Mercantile has assets in excess of $10 billion, and is a multibank holding company headquartered in Baltimore Maryland.  It has 16 banking affiliates in Maryland,one banking affiliate in Delaware and three in Virginia.  The merger, which is subject to regulatoryand F&M Bancorp Shareholder approval, is expected to be completed by theend of 2003.

 

The aggregate amount ofconsideration that Mercantile will pay in the merger has been fixed atapproximately $123.5 million is cash and approximately 10.3 million shares ofits common stock.  These fixed pools ofconsideration were determined based on: (i) an aggregate of 10,740,357 sharesof F&M Bancorp common stock outstanding as of the date of the mergeragreement, (ii) an agreed upon purchase price of $46 per share, (iii) anexchange ratio of 1.2831 based on an agreed upon value of the Mercantile commonstock of $35.85 (the average of the closing sales price of on the NASDAQNational Market System during the ten consecutive trading-day period ended onthe day prior to the date of the Merger agreement), and (iv) an agreement tofix 75% of such aggregate consideration in the form Mercantile common stock and25% in cash.  These pools would increaseonly in the event of the exercise of outstanding options to purchase shares ofF&M Bancorp common stock between March 13, 2003 and the effective time ofthe merger.  If all of such outstandingoptions were exercised, the aggregate amount of consideration payable in themerger would increase to approximately $130.7 million and approximately 10.8million shares.

 

Under the terms of themerger agreement, each share of F&M Bancorp common stock will be convertedto either (i) an amount in cash or (ii) an equivalent value of shares inMercantile common stock.  The value of thecash or Mercantile common stock that an F&M Bancorp shareholder willreceive for each share of F&M Bancorp common stock owned by it will bedetermined as of the ten consecutive trading-day period ending on the thirdcalendar day immediately prior to the effective time of the merger, inaccordance with a formula (including to calculation of a new exchange ratio)based on the average of the closing sales price of the Mercantile common stockon the NASDAQ National Market System during such ten day period.  Thus, while the value of the cash orMercantile common stock that an F&M Bancorp shareholder will receive foreach share of F&M Bancorp common stock owned by it will be equal as of thecalculation date, such value may be more or less than $46 per share dependingupon whether or not the average closing price of the Mercantile common stocksuch ten day period is more of less than $35.85.

 

Each F&M Bancorpshareholder may elect to receive all cash, all Mercantile common stock, or anymixture of Mercantile common stock and cash in exchange for the total number ofshares of F&M Bancorp common stock held by such stockholder.  The Fixed pools of cash and stockconsideration will be allocated among the F&M Bancorp stockholders inaccordance with their individual election; provided, however, that to theextent there is an oversubscription for either the cash or the stock pool, thestockholders electing the oversubscribed consideration will be reduced on a prorata basis as to the amount of such oversubscribed consideration they will beentitled to receive, and will receive an amount of the pool of considerationequivalent in value to the amount of such pro reduction.

 

8

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3.               Earnings PerShare

 

The table below showsdual presentation of earnings per common share and diluted earnings per commonshare and a reconciliation of the numerator and denominator of both earningsper common share calculations.

 
|                                                     |   | **Quarter ended March 31,** |      |
|----------------------------------------------------------|--------|-----------------------------|-----------|
| **(in thousands, except per share data)**                |   | **2003**                    |      | **2002** |   |
|                                                     |   |                        |      |   |   |
| Net income applicable to common stock (numerator)        |   | **$**                       | **7,199** |   | $ | 5,777 |   |
|                                                     |   |                        |      |   |   |
| **EARNINGS PER COMMON SHARE**                            |   |                        |      |   |   |
| Average common shares outstanding (denominator)          |   | **10,738.2**                |      | 10,852.7 |   |
| Per share                                                |   | **$**                       | **0.67**  |   | $ | 0.53 |   |
|                                                     |   |                        |      |   |   |
| **DILUTED EARNINGS PER COMMON SHARE**                    |   |                        |      |   |   |
| Average common shares outstanding                        |   | **10,738.2**                |      | 10,852.7 |   |
| Add:  Stock  options                                |   | **104.8**                   |      | 59.6 |   |
| Diluted average common shares outstanding  (denominator) |   | **10,843.0**                |      | 10,912.3 |   |
| Per share                                                |   | **$**                       | **0.66**  |   | $ | 0.53 |   |

 

4.               OperatingSegments

 

Operating segments asdefined by SFAS No. 131 *Disclosures about Segments of an Enterprise andRelated Information* are components of an enterprise with separatefinancial information.  The componentengages in business activities, from which it derives revenues and incursexpenses and whose operating results management relies on for decision makingand performance assessment. The Bancorp, as defined by this standard, does nothave any segment whose revenues, reported profit and loss, or assets are 10% ormore of the combined revenues of all reporting segments.

 

5.               IntangibleAssets

 

The gross carrying amountof intangible assets and the associated accumulated amortization at March 31 ispresented in the following tables.

 
|                         |   | **March 31, 2003**          |       |
|------------------------------|--------|-----------------------------|------------|
| **(in thousands)**           |   | **Gross  carrying  amount** |       | **Accumulated  amortization** |   | **Valuation  Allowance** |   | **Net  intangible  assets** |   |
|                         |   |                        |       |   |   |   |   |   |   |
| Amortized intangible assets: |   |                        |       |   |   |   |   |   |   |
| Core deposit intangible      |   | **$**                       | **8,565**  | ** ** | **$** | **6,925** | ** ** | **$** | **—** | ** ** | **$** | **1,640** | ** ** |
| Mortgage servicing rights    |   | **1,757**                   | ** ** | **1,054** | ** ** | **410** | ** ** | **293** | ** ** |
| Total                        |   | **$**                       | **10,322** | ** ** | **$** | **7,979** | ** ** | **$** | **410** | ** ** | **$** | **1,933** | ** ** |

 

9

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|                         |   | **March 31, 2002**          |   |
|------------------------------|--------|-----------------------------|--------|
| **(in thousands)**           |   | **Gross  carrying  amount** |   | **Accumulated  amortization** |   | **Valuation  Allowance** |   | **Net  intangible  assets** |   |
|                         |   |                        |   |   |   |   |   |   |   |
| Amortized intangible assets: |   |                        |   |   |   |   |   |   |   |
| Core deposit intangible      |   | $                           | 8,565  |   | $ | 5,963 |   | $ | — |   | $ | 2,602 |   |
| Mortgage servicing rights    |   | 1,757                       |   | 794 |   | — |   | 963 |   |
| Total                        |   | $                           | 10,322 |   | $ | 6,757 |   | $ | — |   | $ | 3,565 |   |

 

The projections of amortization expense shown below for mortgageservicing rights are based on asset balances and the interest rate environmentas of March 31, 2003. Future amortization expense may be significantlydifferent depending upon changes in the mortgage servicing portfolio, mortgageinterest rates and market conditions.

 

The following table showsthe current period and estimated future amortization expense for amortizedintangible assets. Core deposit intangibles are amortized on useful lives of upto 15 years. The Bancorp reviews other intangible assets for impairmentquarterly (except mortgage servicing rights, which are reviewed monthly), orwhenever events or changes in circumstances indicate that their carryingamounts may not be recoverable. For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flow is less than the carrying amount of the asset. Impairmentis recognized by accelerating the write off of the asset to the extent that thecarrying value exceeds the estimated fair value.

 
| **(in thousands)**                         |   | **Core  deposit  intangibles** |   | **Mortgage  servicing  rights** |   | **Total** |   |
|--------------------------------------------|--------|--------------------------------|--------|---------------------------------|--------|-----------|--------|
|                                       |   |                           |   |                            |   |      |   |
| Three months ended March 31, 2003 (actual) |   | $                              | 214    |                            | $      | 65        |   | $ | 279 |   |
|                                       |   |                           |   |                            |   |      |   |
| Year ended December 31, 2003 (estimated)   |   | 700                            |   | 195                             |   | 895       |   |
|                                       |   |                           |   |                            |   |      |   |
| Estimate for year ended December 31,       |   |                           |   |                            |   |      |   |
| 2004                                       |   | 737                            |   | 98                              |   | 835       |   |
| 2005                                       |   | 203                            |   | —                          |   | 203       |   |
| 2006                                       |   | —                         |   | —                          |   | —    |   |
| 2007                                       |   | —                         |   | —                          |   | —    |   |
| 2008                                       |   | —                         |   | —                          |   | —    |   |
|                                            |        |                                |        |                                 |        |           |        |  |  |  |

 

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6.               Commitments

 

Various commitments toextend credit (lines of credit) are made in the normal course of the bankingbusiness. Total unused lines of credit approximated $171.5 million, $154.1million and $149.7million at March 31, 2003, December 31, 2002 and March 31,2002, respectively. In addition, letters of credit are issued for the benefitof customers. Outstanding letters of credit were $27.8 million at March 31,2003, $23.8 million at December 31, 2002 and $24.4 million at March 31, 2002 inaccordance with FASB Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.A liability of $95 thousand for performance under standby letters of credit wasrecorded as of March 31, 2003. All standby letters of credit are supported bycollateral or recourse provisions that are expected to cover the majority ofthese obligations.

 

7.               DerivativeInstruments and Hedging Activities

 

FASB Statement No. 133(SFAS No. 133), *Accounting for Derivative Instruments and Hedging Activities,*andFASB Statement No. 138 (SFAS No. 138), *Accounting for Certain Derivative Instruments andCertain Hedging Activities — an amendment to FASB Statement No. 133,*collectively(SFAS No. 133) establishes accounting and reporting standards for derivative instrumentsand for hedging activities. The Bancorp enters into interest rate locks withmortgage loan customers and forward commitments to sell loans to mortgageinvestors. These are considered derivative instruments under SFAS No. 133.

 

All derivative instrumentsare recognized on the balance sheet at fair value. On the date the Bancorpenters into a derivative contract, the Bancorp designates the derivativeinstrument as (1) a hedge of the fair value of a recognized asset or liabilityor of a unrecognized firm commitment (“fair value hedge”), or (2) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow hedge”).**Fora fair value hedge, changes in the fair value of the derivative instrument andchanges in the fair value of the hedged asset or liability or of anunrecognized firm commitment attributable to the hedged risk are recorded incurrent period net income in the same financial statement category of the hedgeditem. For a cash flow hedge, changes in the fair value of the derivativeinstrument to the extent that it is effective are recorded in othercomprehensive income within stockholders’ equity and subsequently reclassifiedto net income in the same period(s) that the hedged transaction impacts netincome in the same financial statement category as the hedged item.

 

The fair value ofderivative instruments was $480 thousand recorded in other assets and $571thousand recorded in accrued expenses and other liabilities at March 31, 2003.

** **

8.               RecentAccounting Standards

 

InJune 2002, the FASB issued Statement No. 146 (SFAS No. 146), *Accountingfor Cost Associated with Exit or Disposal Activities.*SFAS No. 146addresses financial accounting and reporting for cost associated with exit ordisposal activities.  This statementrequires that a liability for a cost associated with an exit or disposalactivity be recognized and measured initially at fair value only when theliability is incurred. This statement is effective for activities initiatedafter December 31, 2002.The Bancorp adopted this SFAS No. 146 as of January 1,2003 with no material impact on the financial condition or results ofoperations for the quarter ended March 31, 2003.

 

InNovember 2002, the FASB issued FASB Interpretation No. 45, *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers,* an interpretation of FASB Statements No. 5, 57 and 107 andrescission of FASB Interpretation No. 34 (FIN 45).  The initial recognition and measurement provision of FIN 45 areeffective for guarantees issued or modified after December 31, 2002.  Accounting for guarantees issued prior tothis date is unaffected by FIN 45. This

 

11

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statement is effective for the Bancorp and hasbeen adopted as of January 1, 2003. The adoption of this statement did not havea material impact on the Bancorp’s financial position or results of operations.

 

InDecember 2002, the FASB issued Statement No. 148 (SFAS No. 148), *Accountingfor Stock-based Compensation — Transition and Disclosure, an amendment of FASBStatement No. 123.*SFAS No. 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require more prominent and morefrequent disclosures in financial statements about the effects of stock-basedcompensation. This statement is effective for fiscal years ending afterDecember 15, 2002. This statement is effective for the Bancorp and has beenadopted as of January 1, 2003. The adoption of this statement did not have amaterial impact on the Bancorp’s financial position or results of operations.

 

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**ITEM2.   MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

**SUMMARYFINANCIAL DATA**

 
|                                                                               |   | **Quarter ended** |       | **% Change  Mar. 31, 2003  from** |   |
|------------------------------------------------------------------------------------|--------|-------------------|------------|-----------------------------------|--------|
| **(in thousands, except per share  amounts)**                                      |   | **Mar 31,  2003** |       | **Dec 31,  2002**                 |   | **Mar 31,  2002** |   | **Dec 31,  2002** |   | **Mar 31,  2002** |   |
| **For the Period**                                                                 |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Net income                                                                         |   | **7,199**         | ** ** | 6,265                             |   | 5,777 |   | 15 | % | 25 | % |
| Diluted earnings per common share                                                  |   | **0.66**          | ** ** | 0.58                              |   | 0.53 |   | 15 |   | 25 |   |
| Profitability ratios (annualized)                                                  |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Net income to average total assets (ROA)                                           |   | **1.42**          | **%**      | 1.24                              | %      | 1.26 | % | 15 |   | 13 |   |
| Net income applicable to common stock to average  common stockholders equity (ROE) |   | **15.59**         | **%**      | 13.57                             | %      | 13.71 | % | 15 |   | 14 |   |
| Efficiency ratio(1)                                                                |   | **58.64**         | **%**      | 64.61                             | %      | 62.39 | % | (9 | ) | (6 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Dividends paid per common share                                                    |   | **0.29**          | ** ** | 0.28                              |   | 0.28 |   | 4 |   | 4 |   |
| Average common shares outstanding                                                  |   | **10,738,234**    | ** ** | 10,767,352                        |   | 10,852,687 |   | — |   | (1 | ) |
| Diluted average common shares outstanding                                          |   | **10,843,032**    | ** ** | 10,857,658                        |   | 10,912,294 |   | — |   | (1 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Total revenue                                                                      |   | **27,804**        | ** ** | 27,290                            |   | 26,037 |   | 2 |   | 7 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Average loans                                                                      |   | **1,306,446**     | ** ** | 1,269,793                         |   | 1,164,992 |   | 3 |   | 12 |   |
| Average assets                                                                     |   | **2,056,449**     | ** ** | 2,012,166                         |   | 1,860,937 |   | 2 |   | 11 |   |
| Average deposits                                                                   |   | **1,595,580**     | ** ** | 1,569,537                         |   | 1,508,003 |   | 2 |   | 6 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Net interest margin                                                                |   | **4.19**          | **%**      | 4.24                              | %      | 4.34 | % | (1 | ) | (3 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| **At Period End**                                                                  |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Securities available for sale                                                      |   | **627,633**       | ** ** | 618,452                           |   | 557,425 |   | 1 |   | 13 |   |
| Loans                                                                              |   | **1,317,789**     | ** ** | 1,305,348                         |   | 1,170,387 |   | 1 |   | 13 |   |
| Allowance for credit losses                                                        |   | **(13,673**       | **)**      | (13,668                           | )      | (14,132 | ) | — |   | (3 | ) |
| Assets                                                                             |   | **2,098,469**     | ** ** | 2,094,986                         |   | 1,883,523 |   | — |   | 11 |   |
| Deposits                                                                           |   | **1,649,633**     | ** ** | 1,595,139                         |   | 1,532,689 |   | 3 |   | 8 |   |
| Shareholders’ equity                                                          |   | **189,717**       | ** ** | 184,256                           |   | 168,993 |   | 3 |   | 12 |   |
| Tier 1 capital(2)                                                                  |   | **177,491**       | ** ** | 172,648                           |   | 164,848 |   | 3 |   | 8 |   |
| Total capital(2)                                                                   |   | **191,952**       | ** ** | 186,316                           |   | 178,980 |   | 3 |   | 7 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Capital ratios                                                                     |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Shareholders’ equity to assets                                                |   | **9.04**          | **%**      | 8.80                              | %      | 8.97 | % | 3 |   | 1 |   |
| Risk-based capital(2)                                                              |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Tier 1 capital                                                                     |   | **11.85**         | **%**      | 11.74                             | %      | 12.40 | % | 1 |   | (4 | ) |
| Total capital                                                                      |   | **12.82**         | **%**      | 12.67                             | %      | 13.47 | % | 1 |   | (5 | ) |
| Leverage(2)                                                                        |   | **8.64**          | **%**      | 8.59                              | %      | 8.87 | % | 1 |   | (3 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Book value per common share                                                        |   | **17.67**         | ** ** | 17.11                             |   | 15.57 |   | 3 |   | 13 |   |
| Staff (active, full-time equivalent)                                               |   | **728**           | ** ** | 708                               |   | 755 |   | 3 |   | (4 | ) |
| Common Stock Price                                                                 |   |              | ** ** |                              |   |   |   |   |   |   |   |
| High                                                                               |   | **44.94**         | ** ** | 35.00                             |   | 28.85 |   | 28 |   | 56 |   |
| Low                                                                                |   | **28.45**         | ** ** | 30.75                             |   | 25.05 |   | (7 | ) | 14 |   |
| Period end                                                                         |   | **44.01**         | ** ** | 32.00                             |   | 26.99 |   | 38 |   | 63 |   |
| Credit quality                                                                     |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Nonperforming assest / total assets                                                |   | **0.12**          | **%**      | 0.12                              | %      | 0.13 | % | — |   | (8 | ) |
| Net chargeoffs/total loans                                                         |   | **0.16**          | **%**      | 0.12                              | %      | 0.22 | % | 33 |   | (27 | ) |
| Allowance for credit losses/total loans                                            |   | **1.05**          | **%**      | 1.08                              | %      | 1.21 | % | (3 | ) | (13 | ) |

 

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(1)          The efficiency ratio isdefined as noninterest expense divided by the total revenue (net interestincome and noninterest income).

(2)          See the CapitalAdequacy/Ratios section for additional information.

 

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*Statements made in this document, other than statements ofhistorical information, are forward-looking statements that are made pursuantto the safe harbor provisions of Section 21E of the Securities Exchange Act of1934. These forward-looking statements may sometimes be identified by wordssuch as “expect”, “may”, “looking forward”, “we plan”, “we believe”, “areplanned”, “could be” and “currently anticipate”. Although we believe thesestatements, as well as other oral and written forward-looking statements madeby us from time to time, to be true and reasonable, we can give no assurancethat these plans, intentions or expectations will be achieved. Actual results,performance or achievements could differ materially from those contemplated,expressed or implied by the forward-looking statements. Important factors thatcould cause actual results to differ materially from our forward-lookingstatements are set forth in our other filings with the SEC, and in thisdocument under the heading “Risk Factors”, beginning in the section captioned“Management’s Discussion and Analysis of Financial Condition and Results ofOperations”. We caution that the risks and factors discussed below and in suchfilings are not exclusive. We do not undertake to update any forward-lookingstatement that may be made from time to time by or on behalf of the Bancorp.*

** **

OVERVIEW

 

F&M Bancorp is theregistered bank holding company for Farmers & Mechanics Bank (the “Bank”),headquartered in Frederick, Maryland. The Bancorp is a $2.1 billion diversifiedfinancial services company providing banking, insurance, wealth management, andmortgage banking through banking branches, the internet and other distributionchannels to consumers and commercial businesses. The Bank operates 48 communityoffices in Frederick, Howard, Baltimore, Montgomery, Washington, Carroll andAlleghany Counties in Maryland, together with two insurance agencies.

 

Certain amounts in thefinancial review for prior quarters have been reclassified to conform with thecurrent financial statement presentation.

 

Net income for the firstquarter of 2003 reached a record $7.2 million, an increase of 25% compared withearnings of $5.8 million for the first quarter of 2002. Earnings per dilutedshare for the first quarter of 2003 reached a record $0.66 per share, a 25%increase over the prior year’s $0.53 per share results. Return on averageassets (ROA) was 1.42% and return on average equity (ROE) was 15.59% for thefirst quarter of 2003, compared with 1.26% and 13.71%, respectively, for thesame period of 2002.

 

Net interest income on ataxable-equivalent basis was $20.1 million for the first quarter of comparedwith $18.8 million for the same periods of 2002. The Bancorp’s net interestmargin was 4.19% for the first quarter, compared with 4.34% for the sameperiods of 2002.

 

Noninterest incometotaled $8.3 million for the first quarter, compared with $8.0 million and forthe same periods of 2002, a 4% increase. Noninterest expense totaled $16.7million for the first quarter of 2003, compared with $16.8 million for the sameperiods of 2002.

 

The provision for creditlosses was $525 thousand in the first quarter of 2003, compared with $825thousand in the same periods in 2002. During the first quarter of 2003, netcharge-offs were $520 thousand, or .16% of average loans outstanding(annualized), compared with $640 thousand, or .22%, in the first quarter of2002. The provision for credit losses for the first quarter was maintained atthe experience level of net charge-offs. The allowance for credit losses was$13.7 million, or 1.05% of total loans, at March 31, 2003, compared with $13.7million, or 1.08%, at December 31, 2002 and $14.1 million, or 1.21% at March31, 2002.

 

At March 31, 2003, totalnonperforming assets were $2.6 million, or .12% of total assets, compared with$2.5 million, or .12%, at December 31, 2002 and $2.4 million, or .13%, at March31, 2002. Foreclosed assets amounted to $414 thousand at March 31, 2003 andDecember 31, 2002, and $610 thousand at March 31, 2002.

 

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At March 31, 2003, theratio of shareholders’ equity to total assets was 9.04%, compared with 8.97% atMarch 31, 2002. The Bancorp’s total risk-based capital (RBC) ratio at March 31,2003 was 12.82% and its Tier 1 RBC ratio was 11.85%, exceeding the minimumregulatory guidelines of 8% and 4%, respectively for bank holding companies.The Bancorp’s ratios at March 31, 2002 were 13.47% and 12.40%, respectively.The Bancorp’s leverage ratio was 8.64% at March 31, 2003 and 8.87% at March 31,2002, exceeding the minimum regulatory guideline of 3% for bank holdingcompanies.

 

Critical Accounting Policies

 

*Reserve for Credit Losses*

 

The Bancorp has anestablished process to determine the adequacy of the allowance for creditlosses which assesses the risk inherent in its portfolio. This process providesan allowance consisting of two components, allocated and unallocated. To arriveat the allocated component of the allowance, the Bancorp combines estimates ofthe allowance needed for loans analyzed individually (including impaired loanssubject to Statement of Financial Accounting Standards No. 114 (SFAS No. 114), *Accountingby Creditors for Impairment of a Loan*) and loans analyzed on a poolbasis.

 

The determination of theallocated allowance for portfolios of larger commercial and commercial realestate loans involves a review of individual higher-risk transactions, focusingon the accuracy of loan grading, assessments of specific loss indicators, andin some cases, strategies for resolving problem credits. These considerationsare supplemented by the application of loss factors delineated by individualloan grade to the existing distribution of risk exposures, which provides anassessment of inherent losses across the entire wholesale lending portfoliosegment which respond to shifts in portfolio risk indicators. The loss factorsused for this analysis have been derived from tracking historical lossexperience by asset loan grade over a 5-year period. The loan loss allocationsarrived at through this factor methodology are adjusted by management’sjudgement concerning the effect of recent economic events on portfolioperformance.

 

In the case of mosthomogeneous portfolios, such as consumer loans, residential mortgage loans, andsome segments of small business lending, the determination of the allocatedallowance is performed in the aggregate, or pooled, level. For such portfolios,the risk assessment process captures the net charge-offs experienced over thepast year. The historic loss factors are then considered for either positive ornegative adjustment by management to reflect the current risk inherent in theportfolios as of the date presented. These adjustments in the loss factors aretied to management’s evaluation of a number of factors including: 1) changes inthe trend of the volume and severity of past due, classified and non-accrualassets; 2) changes in the nature and volume of the portfolio; 3) changes inlending policies, underwriting standards, or collection practices; and 4) changesin the experience, ability, depth of lending 

management and staff.

 

While coverage of oneyear’s losses is often adequate (particularly for homogeneous pools of loans),the time period covered by the allowance may vary by portfolio, based on theBancorp’s best estimate of the inherent losses in the entire portfolio as ofthe evaluation date. To mitigate the imprecision inherent in most estimates ofexpected credit losses, the allocated component of the allowance issupplemented by an unallocated component. The unallocated component includesmanagement’s judgmental determination of the amounts necessary forconcentrations, economic uncertainties and other subjective factors;correspondingly, the relationship of the unallocated component to the total allowancefor credit losses may fluctuate from period to period.  Although management has allocated a portionof the allowance to specific loan categories, the adequacy of the allowancemust be considered in its entirety.

 

The Bancorp’sdetermination of the level of the allowance and, correspondingly, the provisionfor credit losses rests upon various judgements and assumptions, includinggeneral economic conditions, loan portfolio composition, prior loan lossexperience and the Bancorp’s ongoing examination process and that of itsregulators. The Bancorp has an internal risk analysis and review staff thatcontinuously reviews loan quality and reports the results of its examinationsto the President and Chief Executive Officer, the Board of Directors and its AuditCommittee. Such reviews also assist executive management in establishing thelevel of the allowance.

 

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The Bancorp is examinedannually by the Federal Reserve Board and the State of Maryland, including specificsegments of the loan portfolio.

 

The Bancorp considers theallowance for credit losses of $13.7 million adequate to cover losses inherentin loans, loan commitments and standby and other letters of credit at March 31,2003.

 

*Valuation of Mortgage Servicing Rights*

 

The Bancorp recognizes asassets the right to service mortgage loans for others that were retained uponsales of loan originations. For purposes of evaluating and measuring impairmentof mortgage servicing rights, the Bancorp stratifies its portfolio on the basisof certain risk characteristics including loan type and note rate. Based uponcurrent fair values, mortgage servicing rights are periodically assessed forimpairment. Any such indicated impairment is recognized in income, during theperiod in which it occurs, in a mortgage servicing valuation account which isadjusted each subsequent period to reflect any increase or decrease in theindicated impairment. Mortgage servicing rights are amortized over the periodof estimated net servicing income and take into account appropriate prepaymentassumptions.

 

Key economic assumptions used in measuring anypotential impairment of the servicing rights include the prepayment speed ofthe underlying mortgage loans, the weighted-average life of the loan and thediscount rate. The primary risk of material changes to the value of themortgage servicing rights resides in the potential volatility in the economicassumptions used, particularly the prepayment speed. The Bancorp monitors thisrisk and adjusts its valuation allowance as necessary to adequately reserve forany probable impairment in the portfolio. By adjusting the allowance, asnecessary each quarter, the Bancorp mitigates its risk to material adversechanges in the value of the portfolio. See further discussion in Note 1 andNote 16 to Financial Statements of F&M Bancorp’s 2001 Annual Report on Form10-K.

 

*Valuation of Identifiable Intangible Assets*

** **

Identifiable intangibleassets primarily consist of core deposit intangibles acquired in branch officeacquisitions. Core deposit intangible assets represent the excess of the fairvalue of liabilities assumed over the fair value of tangible assets acquired inbranch office acquisitions. These intangible assets are amortized on anaccelerated basis over an original life of 10 to 15 years. The Bancorp reviewsits intangible assets periodically for other-than-temporary impairment. If suchimpairment is indicated, impairment is recognized by accelerating theamortization of the asset to the extent that the carrying value exceeds theestimated fair value.

 

16

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EARNINGSPERFORMANCE

 

NET INTERESTINCOME

 

Net interest income on ataxable-equivalent basis was $20.1 million in first quarter 2003, up 7% from firstquarter of last year. The increase in net interest income was largely due tosolid earning asset and core deposit growth, offset by a decline in netinterest margin from 4.34 percent a year ago to 4.19 percent in first quarter2003. The average earning asset growth of $191 million included an increase of$141 million in the loan portfolio and $59 million in the securities portfolio,offset by a $9 million decline in short-term funds. The margin compression inthe first quarter reflected the earning asset growth being funded by a greaterproportion of interest-bearing liabilities rather than noninterest-bearingdeposits and equity as well as asset yields declining at a faster rate thaninterest-bearing liability costs. Average funding costs declined 80 basispoints in first quarter 2003, while average net asset yields declined 83 basispoints.

 

An important contributorto the growth in net interest income from first quarter 2003 was a 6% increasein core deposits, the Bancorp’s lowest cost source of funding. Average coredeposits were $1.596 million and $1.508 million and funded 78% and 81% of theBancorp’s average total assets in the first quarter of 2003 and 2002,respectively. Total average interest-bearing deposits increased to $1.336million in first quarter 2003 from $1.283 million a year ago. For the sameperiod, total average noninterest-bearing deposits increased to $259 millionfrom $225 million. While certificates of deposits declined on average from $626million to $619 million, noninterest-bearing checking and other core depositcategories increased on average from $880 million to $1.064 million in firstquarter 2003 reflecting the Bancorp’s success in growing customerrelationships.

 

Individual components ofnet interest income and the net interest margin are presented in the rate/yieldtable on the following page.

 

17

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**AVERAGE BALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENTBASIS)(1)**

 
|                                                                              |   | **Quarter ended Mar. 31,** |          |
|-----------------------------------------------------------------------------------|--------|----------------------------|---------------|
|                                                                              |   | **2003**                   |          | **2002** |   |
| **(in thousands)**                                                                |   | **Average  Balance**       |          | **Interest  income/  expense** |   | **Yields/  rates** |   | **Average  Balance** |   | **Interest  income/  expense** |   | **Yields/  rates** |   |
| **ASSETS**                                                                        |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Interest earning assets:**                                                      |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| Short-term funds                                                                  |   | **$**                      | **3,150**     | ** ** | **$** | **10** | ** ** | **1.29** | **%** | $ | 12,360 |   | $ | 44 |   | 1.44 | % |
| Loans held for sale                                                               |   | **19,400**                 | ** **    | **296** | ** ** | **6.19** | ** ** | 19,082 |   | 292 |   | 6.21 |   |
| Securities available for sale(2)(4);                                              |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury and federal agencies                                                |   | **84,764**                 | ** **    | **767** | ** ** | **3.67** | ** ** | 41,875 |   | 462 |   | 4.47 |   |
| U.S. States and political subdivisions                                            |   | **106,327**                | ** **    | **1,711** | ** ** | **6.53** | ** ** | 118,421 |   | 2,025 |   | 6.93 |   |
| Mortgage-backed securities                                                        |   | **377,718**                | ** **    | **4,157** | ** ** | **4.46** | ** ** | 387,049 |   | 4,702 |   | 4.93 |   |
| Other securities                                                                  |   | **43,086**                 | ** **    | **320** | ** ** | **3.01** | ** ** | 5,882 |   | 41 |   | 2.83 |   |
| Total investment securities                                                       |   | **611,896**                | ** **    | **6,955** | ** ** | **4.61** | ** ** | 553,227 |   | 7,230 |   | 5.30 |   |
| Nonmarketable equity securities                                                   |   | **6,819**                  | ** **    | **84** | ** ** | **5.00** | ** ** | 6,934 |   | 116 |   | 6.78 |   |
| Portfolio Loans(3)(4):                                                            |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| Commercial                                                                        |   | **172,608**                | ** **    | **2,502** | ** ** | **5.88** | ** ** | 159,896 |   | 2,822 |   | 7.16 |   |
| Residential real estate                                                           |   | **356,418**                | ** **    | **5,198** | ** ** | **5.91** | ** ** | 264,514 |   | 4,780 |   | 7.33 |   |
| Commercial real estate                                                            |   | **406,472**                | ** **    | **6,710** | ** ** | **6.69** | ** ** | 335,340 |   | 6,210 |   | 7.51 |   |
| Real estate construction                                                          |   | **103,832**                | ** **    | **1,404** | ** ** | **5.48** | ** ** | 104,419 |   | 1,448 |   | 5.62 |   |
| Consumer installment                                                              |   | **267,116**                | ** **    | **4,743** | ** ** | **7.20** | ** ** | 300,823 |   | 5,802 |   | 7.82 |   |
| Total loans                                                                       |   | **1,306,446**              | ** **    | **20,557** | ** ** | **6.38** | ** ** | 1,164,992 |   | 21,062 |   | 7.33 |   |
| Total interest-earning assets                                                     |   | **1,947,711**              | ** **    | **27,902** | ** ** | **5.81** | ** ** | 1,756,595 |   | 28,744 |   | 6.64 |   |
| Total noninterest-earning assets                                                  |   | **108,738**                |          |   |   |   | ** ** | 104,342 |   |   |   |   |   |
| Total assets                                                                      |   | **$**                      | **2,056,449** |   |   |   |   | ** ** | $ | 1,860,937 |   |   |   |   |   |
|                                                                              |   |                       |          |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES**                                                                   |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                                 |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| Interest-bearing deposits                                                         |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| Savings                                                                           |   | **$**                      | **226,656**   | ** ** | **$** | **498** | ** ** | **0.89** | ** ** | $ | 193,596 |   | $ | 581 |   | 1.22 |   |
| Checking                                                                          |   | **212,000**                | ** **    | **162** | ** ** | **0.31** | ** ** | 197,733 |   | 260 |   | 0.53 |   |
| Money market accounts                                                             |   | **278,182**                | ** **    | **748** | ** ** | **1.09** | ** ** | 266,285 |   | 1,112 |   | 1.69 |   |
| Certificates of deposit                                                           |   | **619,303**                | ** **    | **5,043** | ** ** | **3.30** | ** ** | 625,737 |   | 6,896 |   | 4.47 |   |
| Total interest-bearing deposits                                                   |   | **1,336,141**              | ** **    | **6,451** | ** ** | **1.96** | ** ** | 1,283,351 |   | 8,849 |   | 2.80 |   |
| Short-term borrowings                                                             |   | **177,236**                | ** **    | **366** | ** ** | **0.84** | ** ** | 102,975 |   | 312 |   | 1.23 |   |
| Long-term borrowings                                                              |   | **77,954**                 | ** **    | **946** | ** ** | **4.92** | ** ** | 63,429 |   | 779 |   | 4.98 |   |
| Total interest-bearing liabilities                                                |   | **1,591,331**              | ** **    | **7,763** | ** ** | **1.98** | **%** | 1,449,755 |   | 9,940 |   | 2.78 | % |
| Noninterest bearing liabilities:                                                  |   |                       |          |   |   |   | ** ** |   |   |   |   |   |   |
| Demand deposits                                                                   |   | **259,439**                |          |   |   |   | ** ** | 224,652 |   |   |   |   |   |
| Other liabilities                                                                 |   | **18,411**                 |          |   |   |   | ** ** | 15,606 |   |   |   |   |   |
| Total noninterest bearing liabilities                                             |   | **277,850**                |          |   |   |   | ** ** | 240,258 |   |   |   |   |   |
| Shareholders’ equity                                                         |   | **187,268**                |          |   |   |   | ** ** | 170,924 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                   |   | **$**                      | **2,056,449** |   |   |   |   | ** ** | $ | 1,860,937 |   |   |   |   |   |
| **Net interest income and net interest margin on a  taxable-equivalent basis(4)** |   |                       |          | **$** | **20,139** | ** ** | **4.19** | **%** |   |   | $ | 18,804 |   | 4.34 | % |

 

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(1)          The average prime rateof the Bancorp was 4.56% and 5.17% for the quarters ended March 31, 2003 and2002, respectively. The average three-month London Interbank Offered Rate(LIBOR) was 1.56% and 2.16% for the quarters ended March 31, 2003 and 2002,respectively.

(2)          Yields are based on amortized cost balances computed on a settlement daybasis.

(3)          Loan fee income is included in the interest income calculation, andnonaccrual loans are included in the average loan base upon which the interestrate earned on loans is calculated.

(4)          Interest and yield on obligations of state and political subdivisions andtax-exempt loans are computed on a taxable equivalent basis using U.S.statutory tax rate of 35 percent.

 

18

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PROVISION FOR CREDIT LOSSES

 

The provision for creditlosses for the first quarter of 2003 decreased by $300 thousand over theyear-ago quarter due to the improving credit quality of the loan portfolio. Theprovision for credit losses during the quarter represented approximately 100percent of net charge-offs. Losses incurred in the first quarter were primarilyin the consumer portfolio and were stable compared to previous quarters.

** **

NONINTEREST INCOME

 
| **(in thousands)**                     |   | **Quarter ended Mar. 31** |       | **%  Change** |   |
|----------------------------------------|--------|---------------------------|------------|---------------|--------|
| **2003**                               |   | **2002**                  |
|                                   |   |                      |       |          |   |   |   |
| Service charges on deposit accounts    |   | **$**                     | **2,113**  | ** **    | $      | 2,196 |   | (4 | )% |
| Trust and investment fees:             |   |                      | ** ** |          |   |   |   |
| Asset management and custody fees      |   | **474**                   | ** ** | 611           |   | (22 | ) |
| Mutual fund and annuity sales fees     |   | **242**                   | ** ** | 310           |   | (22 | ) |
| Total trust and investment fees        |   | **716**                   | ** ** | 921           |   | (22 | ) |
| Other fees:                            |   |                      | ** ** |          |   |   |   |
| Cash network fees                      |   | **782**                   | ** ** | 711           |   | 10 |   |
| Charges and fees on loans              |   | **95**                    | ** ** | 69            |   | 38 |   |
| Bank-owned life insurance              |   | **175**                   | ** ** | 123           |   | 42 |   |
| All other fees                         |   | **329**                   | ** ** | 412           |   | (20 | ) |
| Total other fees                       |   | **1,381**                 | ** ** | 1,315         |   | 5 |   |
| Mortgage banking fees:                 |   |                      | ** ** |          |   |   |   |
| Origination and other closing fees     |   | **324**                   | ** ** | 219           |   | 48 |   |
| Net gains on mortgage loan sales       |   | **555**                   | ** ** | 567           |   | (2 | ) |
| Servicing fees, net of amortization    |   | **(201**                  | **)**      | 59            |   | (494 | ) |
| Total mortgage banking fees            |   | **678**                   | ** ** | 845           |   | (19 | ) |
| Insurance                              |   | **2,940**                 | ** ** | 2,650         |   | 11 |   |
| Net gains (losses) on securities sold  |   | **467**                   | ** ** | —        |   | 100 |   |
| Net gains (losses) on sale of property |   | **36**                    | ** ** | 86            |   | (58 | ) |
| Total                                  |   | **$**                     | **8,331**  | ** **    | $      | 8,013 |   | 4 | % |

 

Noninterest income was$8.3 million for first quarter 2003, up 4 percent from $8.0 million in thefirst quarter of last year. Fee income growth generated in the first quarterthrough increases in cash network fees and strong insurance sales were offsetby declines in trust and investment fees. Mortgage banking fees of $678thousand in the first quarter of 2003 were impacted by a $222 thousand chargerecorded for the impairment of mortgage servicing rights. Noninterest incomeduring the first quarter of 2003 also included $467 thousand in gains on salesof securities due to a repositioning of the investment portfolio as part of theongoing asset/liability management strategy of the Bancorp.

 

19

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NONINTERESTEXPENSE

 
| **(in thousands)**                   |   | **Quarter ended Mar. 31** |       | **%  Change** |   |
|--------------------------------------|--------|---------------------------|------------|---------------|--------|
| **2003**                             |   | **2002**                  |
|                                 |   |                      |       |          |   |   |   |
| Salaries                             |   | **$**                     | **7,330**  |          | $      | 7,116 |   | 3 | % |
| Incentive compensation               |   | **846**                   |       | 629           |   | 34 |   |
| Employee benefits                    |   | **1,436**                 |       | 1,912         |   | (25 | ) |
| Occupancy and equipment              |   | **2,231**                 |       | 2,474         |   | (10 | ) |
| Professional services                |   | **566**                   |       | 489           |   | 16 |   |
| Telecommunications                   |   | **326**                   |       | 302           |   | 8 |   |
| Advertising and promotions           |   | **367**                   |       | 504           |   | (27 | ) |
| Computer software and maintenance    |   | **351**                   |       | 342           |   | 3 |   |
| Stationary and office supplies       |   | **366**                   |       | 386           |   | (5 | ) |
| Core deposit intangible amortization |   | **246**                   |       | 215           |   | 14 |   |
| Postage                              |   | **238**                   |       | 260           |   | (8 | ) |
| Other real estate owned              |   | **1**                     |       | 10            |   | (90 | ) |
| All other                            |   | **2,392**                 |       | 2,138         |   | 12 |   |
| Total                                |   | **$**                     | **16,696** |          | $      | 16,777 |   | (0 | )% |

 

Management views theefficiency ratio (the ratio of noninterest expense to the sum of tax equivalentnet interest income and noninterest income) as an important measure of overalloperating expense performance and cost management. Bancorp’s efficiency ratiodecreased to 58.64% for the quarter compared to 62.39% for the comparableperiod in 2002.

 

Salary expenses of $7.3million for the first quarter 2003 were 3% higher then the prior year’s quarterdue to normal merit increases. Incentive compensation increased by 34% due toBancorp’s strong financial performance as measured by our team-basedcompensation and sale programs. Employee benefit costs for the first quarter of2003 were 25% less that the comparable quarter of 2002 due to lower medical claimsincurred during the period.

 

Occupancy expenses forthe quarter of $2.2 million decreased $243 thousand or 10% compared to thefirst quarter of 2002 due to branch consolidation efforts in the previous year.

 

INCOME TAXES

 

For the first quarter of2003, provision for income taxes increased by 27.4% to $3.4 million from theprevious year quarter and was directly related to the increase in pretaxoperating earnings. The first quarter 2003 effective tax rate was 31.18%compared to 31.50% in the prior year as most of the components of the increasedrevenues are fully taxable.

 

20

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BALANCE SHEETANALYSIS

** **

SECURITIES AVAILABLE FOR SALE

 

The following tableprovides the cost and fair value for the major components of securitiesavailable for sale carried at fair value. There were no securities classifiedas held to maturity or trading at the end of the periods presented.

 
|                                                  |   | **March 31, 2003** |        | **December 31, 2002**      |   | **March 31, 2002** |   |
|-------------------------------------------------------|--------|--------------------|-------------|----------------------------|--------|--------------------|--------|
| **(in thousands)**                                    |   | **Cost**           |        | **Estimated  fair  value** |   | **Cost**           |   | **Estimated  fair  value** |   | **Cost** |   | **Estimated  fair  value** |   |
|                                                  |   |               |        |                       |   |               |   |   |   |   |   |   |   |
| Securities of U. S. Treasury and federal agencies     |   | **$**              | **74,591**  | ** **                 | **$**  | **76,866**         |   | $ | 77,809 |   | $ | 79,830 |   | $ | 44,965 |   | $ | 45,388 |   |
| Securities of U. S. states and political subdivisions |   | **98,196**         | ** **  | **102,906**                |   | 104,792            |   | 108,487 |   | 114,654 |   | 116,221 |   |
| Mortgage-backed securities                            |   | **394,172**        | ** **  | **401,335**                |   | 384,530            |   | 391,988 |   | 387,462 |   | 387,578 |   |
| Other                                                 |   | **41,301**         | ** **  | **42,023**                 |   | 33,041             |   | 33,556 |   | 4,048 |   | 3,893 |   |
| Total debt securities                                 |   | **608,260**        | ** **  | **623,130**                |   | 600,172            |   | 613,861 |   | 551,129 |   | 553,080 |   |
| Marketable equity securities                          |   | **2,751**          | ** **  | **4,503**                  |   | 2,751              |   | 4,591 |   | 2,751 |   | 4,345 |   |
|                                                  |   |               |        |                       |   |               |   |   |   |   |   |   |   |
| Total                                                 |   | **$**              | **611,011** | ** **                 | **$**  | **627,633**        |   | $ | 602,923 |   | $ | 618,452 |   | $ | 553,880 |   | $ | 557,425 |   |

** **

The following tableprovides the components of the estimated unrealized net gains on securitiesavailable for sale for the end of each period presented. The estimatedunrealized net gain or loss on securities available for sale is reported on anafter-tax basis as a component of cumulative other comprehensive income.

 
| **(in thousands)**                |   | **March 31,  2003** |   | **December 31,  2002** |   | **March 31,  2002** |   |
|-----------------------------------|--------|---------------------|--------|------------------------|--------|---------------------|--------|
|                              |   |                |   |                   |   |                |   |
| Estimated unrealized gross gains  |   | **17,276**          |   | 16,433                 |   | 6,587               |   |
| Estimated unrealized gross losses |   | **654**             |   | 904                    |   | 3,042               |   |
| Estimated unrealized net gain     |   | **16,622**          |   | 15,529                 |   | 3,545               |   |

 

The weighted averageexpected remaining maturity of the debt securities portion of the securitiesavailable for sale portfolio was 2 years at March 31, 2003. Expected remainingmaturities will differ from contractual maturities because obligations may beprepaid.

 

21

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LOAN PORTFOLIO

 
|                                                                                           |   |              |          |               |       |              |       | **% Change  Mar. 31, 2003 from** |       |
|------------------------------------------------------------------------------------------------|--------|-------------------|---------------|--------------------|------------|-------------------|------------|----------------------------------|------------|
| **(in thousands)**                                                                             |   | **Mar. 31  2003** |          | **Dec. 31,  2002** |       | **Mar. 31  2002** |       | **Dec. 31,  2002**               |       | **Mar. 31  2002** |   |
|                                                                                           |   |              | ** **    |               | ** ** |              | ** ** |                             | ** ** |   | ** ** |
| Commercial(1)                                                                                  |   | **$**             | **167,746**   |               | $          | 174,975           |       | $                                | 160,211    | ** ** | **(4** | **)%** | **5** | **%** |
| Residential real estate(2)                                                                     |   | **363,708**       |          | 348,289            |       | 269,936           | ** ** | **4**                            | ** ** | **35** | ** ** |
| Commercial mortgage                                                                            |   | **414,294**       |          | 403,870            |       | 339,442           | ** ** | **3**                            | ** ** | **22** | ** ** |
| Real estate construction                                                                       |   | **110,824**       |          | 105,047            |       | 103,309           | ** ** | **5**                            | ** ** | **7** | ** ** |
| Consumer installment                                                                           |   | **261,217**       |          | 273,167            |       | 297,489           | ** ** | **(4**                           | **)**      | **(12** | **)** |
| Total loans (net of unearned income, including net  deferred loan fees, of $785, $699 and $150 |   | **$**             | **1,317,789** |               | $          | 1,305,348         |       | $                                | 1,170,387  | ** ** | **1** | **%** | **13** | **%** |

 

----

(1)          Includes agriculturalloans (loans to finance agricultural production) of $206 thousand, $308thousand and $417 thousand at March 31, 2003, December 31, 2002 and March 31,2002, respectively.

(2)          Includes agriculturalloans that are secured by real estate of $6,778 thousand, $6,516 thousand and$5,570 thousand at March 31, 2003, December 31, 2002 and March 31, 2002,respectively.

 

NONACCRUAL LOANS AND OTHER ASSETS

 

The table on the nextpage presents comparative data for nonaccrual loans and other assets.Management’s classification of a loan as nonaccrual does not necessarilyindicate that the principal of the loan is uncollectible in whole or in part.The Bancorp anticipates changes in the amount of nonaccrual loans that resultfrom increases in loans outstanding, changes in borrower’s circumstances orfrom resolutions of loans in the nonaccrual portfolio. The performance of anyindividual loan can be affected by external factors, such as the interest rateenvironment or factors particular to a borrower such as actions taken by aborrower’s management.

 

NONACCRUAL LOANS AND OTHER REAL ESTATE OWNED

 
| **(in thousands)**                                    |   | **Mar. 31,  2003** |       | **Dec. 31,  2002** |   | **Mar. 31,  2002** |   |
|-------------------------------------------------------|--------|--------------------|------------|--------------------|--------|--------------------|--------|
|                                                  |   |               |       |               |   |               |   |
| Nonaccrual loans:                                     |   |               |       |               |   |               |   |
| Commercial                                            |   | **$**              | **1,397**  | ** **         | $      | 1,186              |   | $ | 1,667 |   |
| Residential real estate                               |   | **—**         | ** ** | 126                |   | 127                |   |
| Commercial mortgage                                   |   | **481**            | ** ** | 461                |   | 2                  |   |
| Real estate construction                              |   | **71**             | ** ** | 71                 |   | —             |   |
| Consumer installment                                  |   | **225**            | ** ** | 233                |   | 26                 |   |
| Total nonaccrual loans                                |   | **$**              | **2,174**  | ** **         | $      | 2,077              |   | $ | 1,822 |   |
| As a percentage of total loans                        |   | **0.16**           | **%**      | 0.16               | %      | 0.16               | %      |
|                                                  |   |               | ** ** |               |   |               |   |
| Other real estate owned                               |   | **414**            | ** ** | 414                |   | 610                |   |
| Total nonaccrual loans and other real estate owned    |   | **$**              | **2,588**  | ** **         | $      | 2,491              |   | $ | 2,432 |   |
| As a percentage of total assets                       |   | **0.12**           | **%**      | 0.12               | %      | 0.13               | %      |
| Loans past due 90 days as to interest & principal |   | **$**              | **917**    | ** **         | $      | 1,191              |   | $ | 1,302 |   |

 

22

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Loans are placed onnonaccrual status when, in the opinion of management, reasonable doubt existsas to the full, timely collection of interest or principal, or a specific loanmeets the criteria for nonaccrual status established by regulatory authorities.When a loan is placed on nonaccrual status, all interest previously accrued butnot collected is reversed against current period interest income. No interestis taken into income on nonaccrual loans until such time the borrower demonstratessustained performance over a period of time in accordance with contractualterms and is removed from nonaccrual status.

 

Other real estate ownedincludes real estate acquired by foreclosure (in partial or completesatisfaction of debt), or otherwise surrendered by the borrower to Bancorp’spossession. Other real estate owned is recorded at the lower of cost or fairvalue on the date of acquisition or transfer from loans. Write-downs to fairvalue at the date of acquisition are charged to the allowance for creditlosses. Subsequent to transfer, these assets are adjusted through a valuationallowance to the lower of the net carrying value or the fair value (net ofestimated selling expenses) based on periodic appraisals

 

Loans contractually pastdue 90 days or more as to interest or principal, but not included in nonaccrualloans are both well-secured and in the process of collection.

 

ALLOWANCE FOR CREDIT LOSSES

** **
|                                                                         |   | **Quarter ended**   |       |
|------------------------------------------------------------------------------|--------|---------------------|------------|
| **(in thousands)**                                                           |   | **March 31,  2003** |       | **March 31,  2002** |   |
|                                                                         |   |                |       |   |   |
| Balance, beginning of period                                                 |   | **$**               | **13,668** | ** ** | $ | 13,947 |   |
|                                                                         |   |                | ** ** |   |   |
| Provision for credit losses                                                  |   | **525**             | ** ** | 825 |   |
|                                                                         |   |                | ** ** |   |   |
| Loan charge-offs:                                                            |   |                | ** ** |   |   |
| Commercial                                                                   |   | **62**              | ** ** | 73 |   |
| Residential mortgage                                                         |   | **133**             | ** ** | 8 |   |
| Commercial mortgage                                                          |   | **—**          | ** ** | — |   |
| Real estate construction                                                     |   |                | ** ** | — |   |
| Consumer                                                                     |   | **945**             | ** ** | 1,261 |   |
| Total loans charged-off                                                      |   | **1,140**           | ** ** | 1,342 |   |
| Loan recoveries:                                                             |   |                | ** ** |   |   |
| Commercial                                                                   |   | **125**             | ** ** | 26 |   |
| Residential mortgage                                                         |   | **2**               | ** ** | — |   |
| Commercial mortgage                                                          |   | **1**               | ** ** | 1 |   |
| Real estate construction                                                     |   | **—**          | ** ** | — |   |
| Consumer                                                                     |   | **492**             | ** ** | 675 |   |
| Total loan recoveries                                                        |   | **620**             | ** ** | 702 |   |
| Net charge-offs                                                              |   | **520**             | ** ** | 640 |   |
|                                                                         |   |                | ** ** |   |   |
| Balance, end of period                                                       |   | **$**               | **13,673** | ** ** | $ | 14,132 |   |
|                                                                         |   |                | ** ** |   |   |
| Total net loan charge-offs as a percent of average  total loans (annualized) |   | **0.16**            | **%**      | 0.22 | % |
| Allowance as a percentage of total loans                                     |   | **1.05**            | **%**      | 1.21 | % |

 

23

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The Bancorp considers theallowance for loan losses of $13.7 million adequate to cover losses inherent inloans, loan commitments and standby and other letters of credit at March 31,2003. During the quarter a comprehensive review of the allowance is performedconsidering such factors as the levels of loans outstanding, loss experience,delinquency levels, certain individual loan reviews, and an evaluation of theregional and national economic environment. The credit quality of the loanportfolio remains exceptionally strong with very low levels of impaired loansand declining historical loss ratios which are the primary drivers of thenecessary allowance for credit losses.

 

DEPOSITS

 

The following table showscomparative detail of deposits.

 
| **(in thousands)**                  |   | **March 31,  2003** |          | **December 31,  2002** |   | **March 31,  2002** |   |
|-------------------------------------|--------|---------------------|---------------|------------------------|--------|---------------------|--------|
|                                |   |                |          |                   |   |                |   |
| Noninterest-bearing demand deposits |   | **$**               | **294,382**   |                   | $      | 264,965             |   | $ | 238,430 |   |
| Interest-bearing deposits:          |   |                |          |                   |   |                |   |
| Checking                            |   | **216,909**         |          | 220,509                |   | 213,335             |   |
| Savings                             |   | **234,428**         |          | 217,342                |   | 205,227             |   |
| Money market                        |   | **285,175**         |          | 271,409                |   | 269,048             |   |
| Certificates of deposit             |   | **618,739**         |          | 620,914                |   | 606,649             |   |
| Total deposits                      |   | **$**               | **1,649,633** |                   | $      | 1,595,139           |   | $ | 1,532,689 |   |

 

CAPITALADEQUACY/RATIOS

 

The Bancorp and its subsidiarybank are subject to various regulatory capital adequacy requirementsadministered by the Federal Reserve Board. Risk-based capital (RBC) guidelinesestablish a risk-adjusted ratio relating capital to different categories ofassets and off-balance sheet exposures.

 
|                                                |   | **Actual** |   | **For capital  adequacy purposes** |   | **To be well  capitalized under  the FDICIA  prompt corrective  action provisions** |   |
|-----------------------------------------------------|--------|------------|--------|------------------------------------|--------|-------------------------------------------------------------------------------------|--------|
| **(in thousands)**                                  |   | **Amount** |   | **Ratio**                          |   | **Amount**                                                                          |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                                |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| As of March 31, 2003:                               |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)             |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                                     |   | $          | 192    |                               | 12.82  | %                                                                                   | $      | 120 |   | 8.00 | % | $ | 150 |   | 10.00 | % |
| Farmers & Mechanics Bank                        |   | $          | 184    |                               | 12.35  |                                                                                | $      | 119 |   | 8.00 |   | $ | 149 |   | 10.00 |   |
|                                                |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Tier 1 capital (to risk-weighted assets)            |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                                     |   | $          | 177    |                               | 11.85  | %                                                                                   | $      | 60 |   | 4.00 | % | $ | 90 |   | 6.00 | % |
| Farmers & Mechanics Bank                        |   | $          | 170    |                               | 11.43  |                                                                                | $      | 60 |   | 4.00 |   | $ | 89 |   | 6.00 |   |
|                                                |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Tier 1 capital (to average assets) (Leverage ratio) |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                                     |   | $          | 177    |                               | 8.64   | %                                                                                   | $      | 82 |   | 4.00 | % | $ | 103 |   | 5.00 | % |
| Farmers & Mechanics Bank                        |   | $          | 170    |                               | 8.36   |                                                                                | $      | 81 |   | 4.00 |   | $ | 102 |   | 5.00 |   |

 

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CONTRACTUAL OBLIGATIONSAND OTHER COMMITMENTS

 

Through the normal courseof operations, the Bancorp has entered into certain contractual obligations andcommitments. Such obligations generally relate to the funding of operations aswell as leases for premises and equipment. As a financial services provider,the Bancorp routinely enters into commitments to extend credit, including loancommitments, standby letters of credit and financial guarantees. Whilecontractual obligations represent future cash requirements of the Bancorp, aportion of commitments to extend credit are likely to expire without beingdrawn upon. Such commitments are subject to the same credit policies andapproval processes accorded to loans made in the regular course of business.FIN 45 has been adopted by the Bancorp as of January 1, 2003 and has beenapplied to all such commitments that fall under this statement.

 

ASSET/LIABILITY AND MARKET RISK MANAGEMENT

** **

Asset/liabilitymanagement comprises the evaluation, monitoring, and management of theBancorp’s interest rate risk, market risk and liquidity and funding. TheAsset/Liability Management Committee (ALCO) maintains oversight of these risks.The Committee is comprised of senior financial and senior business executives.

 

INTEREST RATE RISK

 

Interest rate risk, oneof the more prominent risks in terms of potential earnings impact, is aninevitable part of being a financial intermediary. For more information, see“Market Risk and Asset/Liability Management” in the Bancorp’s 2002 AnnualReport on Form 10-K.

 

Managementbelieves that medium term (12-month horizon) interest rate risk is bestmeasured by simulation modeling.  Thisanalysis calculates expected net interest income based upon historical trends,spreads to market rates, historical market relationships, prepayment behaviorand current and expected product offerings. The bank currently maintains a modest sensitivity to changes in interestrates.  For example, if rates were torise instantaneously by 1.00% or 2.00%, net interest income would increase by0.3% and decline 1.0%, respectively. Conversely, if rates were to decline instantaneously, net interestincome over the next 12 months would decline by 1.7% and 7.4%, respectively.The principal source of risk to net interest income in a falling rate scenariois that certain short-term market rates and a majority of the Bank’s depositrates are currently below 2.0%. Since these rates cannot decline below a floorrate of 0%, these liability products will not fully re-price in the down ratescenarios.

 

Computations ofprospective effects of hypothetical interest rate changes are based on manyassumptions, including relative levels of market interest rates, loanprepayments and changes in deposit levels. They are not intended to be a forecast and should not be relied upon asindicative of actual results.  Further,the computations do not contemplate certain actions that management could takein response to changes in interest rates.

 

LIQUIDITY AND FUNDING

 

The objective ofeffective liquidity management is to ensure that the Bancorp can meet customerloan requests, customer deposit maturities/withdrawals and other cashcommitments efficiently under both normal operating conditions as well as underunforeseen and unpredictable circumstances of industry or market stress. Toachieve this objective, ALCO establishes and monitors liquidity guidelinesrequiring sufficient asset based liquidity to cover potential fundingrequirements and to avoid over-dependence on volatile, less reliable fundingsources. The Bancorp manages liquidity at both the parent and subsidiary levelsthrough active management of the balance sheet.

 

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In addition to theimmediately liquid resources of cash and due from banks and federal funds sold,asset liquidity is provided by the debt securities in the securities availablefor sale portfolio. Asset liquidity is further enhanced by the Bancorp’sability to sell loans in secondary markets through whole-loan sales.

 

Core customer depositshave historically provided the Bancorp with a sizeable source of relativelystable and low-cost funds.

 

Long-term debt, andshort-term borrowings (federal funds purchased and securities sold underrepurchase agreements and other short-term borrowings) mostly provide theremaining funding of assets. The Bank also has extensive access to funds fromits membership in the Federal Home Loan Bank of Atlanta.

 

CAPITAL MANAGEMENT

 

The Bancorp has an activeprogram for managing shareholders’ equity. The objective of effective capitalmanagement is to produce long-term returns by opportunistically utilizingcapital when returns are perceived to be high and issuing/accumulating capitalwhen the costs of doing so is perceived to be low.

 

Uses of capital includeinvestments for organic growth, acquisitions of banks and other financial servicescompanies, dividends and share repurchases. During the first three months of2003, the Bancorp’s consolidated assets increased by $141 million, or 8%.During 2001, the Board of Directors authorized the repurchase of up to 500,000shares of the Bancorp’s outstanding common stock. At March 31, 2003, the totalremaining common stock repurchase authority was approximately 140 thousandshares.

 

Sources of capitalinclude retained earnings and common stock issuance. In the first three monthsof 2003, total net income was $7.2 million and the change in retained earningswas $4.1 million after payment of $3.1 million in common stock dividends.

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Information required bythis item as of December 31, 2002 is set forth in “*Asset Liability and Market RiskManagement”* on pages 32-34 of the registrant’s 2002 Annual Report onForm 10-K for the year ended December 31, 2002. There was no material change insuch information as of March 31, 2003.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

Within the ninety daysprior to the filing of this report, the Bancorp’s management, under thesupervision and with the participation of the Company’s Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of the design andoperation of the Bancorp’s disclosure controls and procedures. Based on theevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat the Bancorp’s disclosure controls and procedures were effective. Therewere no significant changes in the Bancorp’s internal controls or in otherfactors subsequent to the date of the evaluation that could significantlyaffect those controls.

 

FACTORS THAT MAY AFFECT FUTURE RESULTS

 

We make forward-lookingstatements in this report and from time to time in other reports and proxystatements we file with the SEC. Also, our senior management might makeforward-looking statements orally to analysts, investors and others. Broadlyspeaking, forward-looking statements include:

•                  descriptionsof plans or objectives of our management for future operations, products orservices;

•                  descriptionsof assumptions underlying or relating to critical accounting estimates andprojections.

 

In this report, forexample, we make forward-looking statements about:

•                  futurecredit losses and non-performing assets;

•                  futurecash requirements relating to commitments to extend credit;

•                  futureamortization expense;

•                  theimpact of new accounting standards;

•                  andthe impact of interest rate changes on our net interest income.

 

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Forward-lookingstatements discuss matters that are not historical facts. These forward-lookingstatements may sometimes be identified by words such as “expect”, “may”.“looking forward”, “we plan”, “we believe”, “are planned”, “could be”, and“currently anticipate”. Although we believe these statements, as well as otheroral and written forward-looking statements made by us from time to time, to betrue and reasonable, we can give no assurance that these plans, intentions orexpectations will be achieved. Actual results, performance or achievementscould differ materially from those contemplated, expressed or implied by theforward-looking statements.

 

There are severalfactors—many beyond our control—that could cause results to differsignificantly from our expectations. Some of these factors are described below.Other factors, such as credit, market, operational, liquidity, interest rateand other risks, are described elsewhere in this report (see, for example,“Item 2—Management’s Discussion and Analysis of Financial Condition and Resultsof Operations—Balance Sheet Analysis” and –Asset/Liability and Market RiskManagement”). Factors relating to regulation and supervision of the Bancorp aredescribed in our Annual Report on Form 10-K for the year ended December 31,2002.

 

# **IndustryFactors**

** **

**As a financial services company, our earnings aresignificantly affected by business and economic conditions.**

** **

Our earnings are impactedby business and economic conditions in the United States and the Marylandeconomic region. These conditions include short-term and long-term interestrates, inflation, monetary supply, and the strength of the U.S. economy andMaryland economies in which we operate. Business and economic conditions thatnegatively impact household or business incomes could decrease demand for theBancorp’s products and increase the number of customers who fail to pay theirloans.

 

**Our earnings are significantly affected by the fiscal and monetarypolices of the federal government and its agencies.**

** **

The Board of Governors ofthe Federal Reserve System regulates the supply of money and credit in theUnited States. Its policies significantly impact our cost of funds for lendingand investing and the return we earn on those loans and investments, both ofwhich impact our net interest margin, and can materially affect the value offinancial instruments we hold. Its policies also can affect our borrowers,potentially increasing the risk that they may fail to repay their loans.Changes in Federal Reserve Board policies are beyond our control and hard topredict or anticipate.

 

**The financial services industry is highly competitive.**

** **

We operate in a highlycompetitive industry which could become even more competitive as a result oflegislative, regulatory and technological changes and continued consolidationof banks. Banks, securities firms and insurance companies can now merge bycreating a new type of financial services company called a “financial holdingcompany”, which can offer virtually any type of financial service. Many of ourcompetitors have fewer regulatory constraints and some have lower coststructures.

 

**We are heavily regulated by federal and state agencies.**

** **

The holding company andits subsidiaries are heavily regulated at the federal and state levels. Thisregulation is to protect customers, federal deposit insurance funds and thebanking system as a whole, not security holders. Changes to statutes,regulations and regulatory policies, could affect us in substantial andunpredictable ways including limiting the types of financial services andproducts we may offer and increasing the ability of non-banks to offercompeting financial services and products. Also, our failure to comply with laws,regulations and policies could result in sanctions by regulatory agencies anddamage our reputation. For more information, refer to the “Regulation andSupervision” section in our Annual Report on Form 10-K for the year endedDecember 31, 2002.

 

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# **CompanyFactors**

** **

**Maintaining or increasing our market share depends on marketacceptance and regulatory approval of new products and services.**

** **

Our success depends, inpart, on our ability to adapt our products and services to evolving industrystandards and the changing need of our customers. There is increasing pressureon financial service companies to provide products and services at lowerprices. This can reduce our net interest margin and revenues from our fee-basedproducts and services. Also, the wide-spread adoption of new technologies,including internet-based services, could require us to make substantialinvestments to modify or adapt our existing products and services.

 

**The holding company relies on dividends from its subsidiariesfor most of its revenues.**

** **

The holding company is aseparate and distinct legal entity from its subsidiaries. It receivessubstantially all of its revenue from dividends from its subsidiaries. Thesedividends are the principal source of funds to pay dividends on the holdingcompany’s common stock. Various federal and state laws and regulations limitthe amount of dividends that our bank and certain non-bank subsidiaries may payto the holding company. For more information, refer to “Dividend Restrictions”in our Annual Report on Form 10-K as of December 31, 2002.

 

**We have businesses other than banking.**

** **

We are a diversifiedfinancial services company. In addition to banking, we provide insurance,wealth management, and mortgages. Although we believe our diversity helpsmitigate the impact to the Bancorp when downturns affect any one-business line,it also means that our earnings could be subject to different risks anduncertainties. We discuss some examples below.

 

*Mortgage Banking*. The impact of interestrates on our mortgage banking business can be large and complex. Changes ininterest rates can impact loan origination fees and gains on mortgage loanssold. A decline in mortgage rates might be expected to increase the demand formortgages as borrowers refinance. Conversely, in a constant or increasing rateenvironment, we would expect fewer loans to be refinanced and a decline in ourfee income.

 

*Wealth Management.* The impact of changesin the U.S. stock market on our wealth management business can be large. Asmuch of our fee income is derived based on assets under management, the loss invalue of those assets due to stock market declines can significantly reduce ourfee income. Also, if market conditions are volatile many of our investors limittheir mutual fund investments and in some cases withdraw their funds to investin safer investment alternatives.

 

# **LegislativeRisk**

** **

Our business model reliesheavily on our ability to share information between the team of companies ownedby F&M Bancorp to better satisfy our customers’ needs. Future laws thatrestrict our ability to share information about customers could negativelyimpact our revenue and profit.

 

**Our stock price can be volatile.**

** **

Our stock price canfluctuate widely in response to a variety of factors including:

•                  actualor anticipated variations in our quarterly operating results;

•                  recommendationsby security analysts;

•                  operatingand stock price performance of other companies that investors deem comparableto us:

•                  significantacquisitions or business combinations by or involving us or our competitors;

•                  newsreports relating to trends, concerns and other issues in the financial servicesindustry; and

•                  changesin government regulations.

 

General marketfluctuations, industry factors and general economic trends, interest ratechanges, or credit loss trends, also could cause our stock price to decreaseregardless of our operating results.

 

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**PARTII - Other Information**

 

**Item4.    Submission of Matters to a Vote ofSecurity Holders**

 

(d) F&MBancorp and Mercantile Bankshares Corporation recently announced a definitivemerger agreement, subject to shareholder and regulatory approval. As a result,we will not be holding our Annual Meeting of Stockholders as previouslyscheduled for April 15, 2003. Instead, we will provide you with a prospectusand additional information regarding the merger transaction in the comingmonths, including the date for a Special Meeting of Stockholders for thepurpose of voting on the merger.

 

**Item6.    Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 

99.1 CEO Certification ofcorporate responsibility for financial reports. Filed as an exhibit hereto andincorporated herein by reference

 

99.2 CFO Certification ofcorporate responsibility for financial reports. Filed as an exhibit hereto andincorporated herein by reference

 

(b)                                 Reports on Form 8-K

 

Form 8-K, filed datedMarch 13, 2003, Item 5.

Form 8-K, filed datedApril 21, 2003, Item 5.

Form 8-K, filed datedApril 25, 2003, Item 5.

 

**Signatures**

 

Pursuant to therequirements of the Securities Exchange Act of 1934 the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |         | F&M BANCORP   |              |
|--------|--------------|-------------------|-------------------|
|   |         | (Registrant)      |
|   |         |              |
|   |         |              |
|   | May 14, 2003 |              |              |   | /s/ Faye E. Cannon |   |
| Date   |         |              | FAYE E. CANNON    |
|   |         |              | PRESIDENT AND CEO |
|   |         |              |
|   |         |              |
|   | May 14, 2003 |              |              |   | /s/ Kaye A. Simmons |   |
| Date   |         |              | KAYE A. SIMMONS   |
|   |         | CFO AND TREASURER |
|        |              |                   |                   |  |  |  |  |  |

 

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